Obama’s First Moves on the Economy

President-elect Obama cannot indulge in a measured transition. He is compelled by events to act decisively, through quick selection of a Treasury Secretary who can work with incumbent Henry Paulson on the banking crisis and by helping House Speaker Nancy Pelosi fashion a stimulus package that Congress should pass in a post-election session.

The Banks

The country is in the grips of the largest financial crisis since the Great Depression, and the Federal Reserve and Treasury are throwing more than one trillion dollars at the banks through loans and equity purchases. Yet, they have imposed few conditions on the management of the banks.

Lending rates remain high and funds scarce for mortgages and worthwhile business loans. Meanwhile, Paulson is scurrying around considering ad-hoc investments in the likes of General Motors to finance an ill-conceived merger with Chrysler. The unfolding mess at AIG should indicate that giving broken institutions cash without compelling meaningful changes in management strategy and compensation incentives for executives does not generate the results.

J.P. Morgan’s announcement that it will rework about $70 billion in mortgages by writing down balances owed and restructuring payments may be the exception that proves the rule. Obama needs a Treasury Secretary that will compel the nation’s largest banks, which already have received billions in equity and loans, to do the same, and to rebuild the securitization market that pipelines funds from insurance companies and pension funds to regional banks, mortgage brokers and finance companies that are too cash starved to help worthy homebuyers and businesses.

Stimulus Package

A recession of unusual proportions is unfolding. Owing to the credit crisis and housing collapse and excessive borrowing to finance a huge trade deficit, built on too much imported oil and subsidized Chinese imports, the economy is entering a recession that may not be self correcting, unlike other post World War II corrections.

Near-term, compelling private efforts to rework mortgages in the J.P. Morgan mode, as a condition for federal largess to the banks, is essential; however, a second stimulus package in multiple installments to limit the depth of the recession is necessary too.

The lesson of the last stimulus package is clear. Tax rebates gave consumer spending a two month boost but not much else. Too much was spent on imports at the mall, and the money did not do much to stem job losses, even in retailing.

Rather, a stimulus package that focused on roads, schools and other public buildings would do much more to generate domestic employment, directly in construction and through purchases of materials and fixtures to refit buildings.

Any stimulus will require additional federal borrowing. A stimulus package spent on roads and other needed public infrastructure will leave a legacy in capital improvements that assist growth now and in the future.

Fixing Structural Issues

Longer term, the huge trade deficit, caused by too much imported oil and intervention by Asian governments in currency markets to boost their exports and ship unemployment here, had a lot to do with flooding U.S. capital markets with cheap funds and creating the first credit bubble. President-elect Obama waxed a lot about free trade agreements in his campaign but failed to adequately explain how he would fix either the oil or Asian-trade messes.

Investments in alternative energy sources, as Obama has proposed, can’t fix the oil import problem alone. Both drilling off shore and windmills, as well as much tougher mileage standards, are needed to make America less dependent on unfriendly Middle East states.

If China and others won’t stop subsidizing their exports by buying U.S. dollars to keep their currencies and exports artificially cheap, then offsetting taxes on purchases of yuan and other currencies are in order to encourage trade based on comparative advantage.

Obama has not said nearly enough about conventional energy development or the China trade problem. Come January, he needs to implement policies on these issues or fixing the banks will only lead to another credit bubble and crisis, the stimulus package will prove a palliative, and neither will usher in lasting prosperity.

Peter Morici is a professor at the University of Maryland School of Business and former Chief Economist at the U.S. International Trade Commission.